Authored by :
Michael G. Dow, CAIA, CFA, CPA, Chief Investment Officer
Julien R. Frazzo, Director of Risk Management and Securities Research
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The Quick Facts
- U.S. equities staged a stellar comeback in July despite higher-than-expected inflation print
- Federal Reserve hikes rates 75bps but pivots to data dependency going forward
- 10-Year U.S. Treasury yields record the biggest one-month decline since March 2020 to 2.65%
- Negative U.S. GDP print for the second straight quarter
- All eyes are on the next inflation print on August 10, 2022
After a tumultuous first half of the year, U.S. equities staged a stellar comeback in July, driven by big tech outperformance and anticipation of a potential slowing in the pace of future rate hikes by the Federal Reserve (the Fed). The S&P 500 posted a gain of 9.2%, its best month since November 2020, while the Nasdaq had its strongest monthly performance since April of that same year.
Stocks shrugged off a second consecutive negative GDP print, a 75bp rate hike from the Fed, and higher-than-expected inflation data while corporate earnings kicked off. The initial estimate for 2Q 2022 GDP showed a -0.9% drop, on the heels of a -1.6% decline in 1Q (QoQ annualized). This was the advance estimate and will be revised, but two negative quarters is the definition of a recession in many countries. If we are already in an as-yet-undeclared recession, it would be a very strange one. Recessions do not typically coincide with record-low unemployment, plentiful job openings, and crowded airports.
The Fed and inflation data are paramount; July also saw the kickoff of the 2Q 2022 earnings season. Like last quarter, corporates will have difficult comps versus unusually high earnings growth in 2Q 2021, likely leading to one of the lowest earnings growth rates since 4Q 2020. Despite worrisome signals from economic proxies like Walmart, the earnings season thus far has turned out to be brighter than expected, with about 75% of the S&P 500 firms beating analyst estimates. That is fueling expectations that corporate America may be able to weather the storm of high inflation, jumbo-sized rate hikes, and slowing growth.
All equity industry sectors began 3Q 2022 in positive territory, with Consumer Discretionary leading the way at 18.4%. Technology stocks also returned double digits in July, ending higher by 13.5%, followed by Energy, Industrials, Real Estate and Financials, all of which returned north of 7.0%. Communication Services, Healthcare, and Consumer Staples lagged, each returning below 4.0% in July.
The Russell 1000 Value underperformed the Russell 1000 Growth by 5.4% in July, giving back about a third of the outperformance of 15.8% through 1H 2022, signaling at least a temporary return to risk taking. The ESG segment of the market, as measured by the MSCI USA ESG Select Index, was up 9.6% in July, 0.4% more than the S&P 500. Over the last three years, the ESG index is up 47.9% and approximately 3.9% ahead of the S&P 500 on a total return basis. Investing outside of the U.S. was unhelpful in July. The MSCI Emerging Markets Index posted a 0.2% loss in July and is now down 17.8% YTD. The MSCI EAFE (Europe, Australasia, and the Far East) Index was up 5.0% in July, underperforming the U.S. Large Cap equity benchmark by 4.2%. After a period of underperformance earlier this year, U.S. equities (as measured by the S&P 500) are now beating both the MSCI Emerging Markets and EAFE as of the end of July.
Despite the Fed’s continued commitment to bringing inflation back down to its target rate, the market’s expectation turned to an easing of the frontloaded rate hikes, with “bad news is good news” coming back into play. Inflation data continued its trend of unwelcome surprises, as the peak inflation narrative failed once again with a YoY headline CPI (Consumer Price Index) print of 9.1% vs. expected 8.8%. Additionally, initial jobless claims ended the month at an eight-month high, with a flurry of high-profile hiring freezes and layoff announcements. Finally, consumer credit continued to climb, while personal savings fell to levels last seen in 2016.
On July 27, the Fed raised interest rates by three-quarters of a percentage point, its second consecutive supersize rate increase and a move that took its policy setting to a range of 2.25% to 2.50%. That is roughly what policymakers think of as a neutral setting, one that neither stokes nor slows growth, and further increases in interest rates will begin to actively hit the brakes on the economy. Given that fact, Jerome Powell, the Fed chair, said policymakers would now set rates meeting by meeting rather than committing to a broad plan well in advance. Investors took that as a sign that the central bank was likely to slow rate moves sharply in the coming months as the economy slows.
Bond market pricing suggests that investors think the Fed may begin to cut interest rates next year. The yield on the benchmark U.S. 10-year Treasury saw a record one month decline of 36bps to 2.65% at the end of July. The 2-year saw a smaller 7bps move, with the yield moving from 2.95% at the beginning of the month to 2.88% at the end of July. The spread between the 10-year and the 2-year yields went from being positive by 6bps at the end of June to negative territory by 24bps, a 30bps move in total, at the end of July. With U.S. Treasuries serving as the risk-free benchmark for more than $50 trillion of fixed-income assets, elevated volatility in their yields could make it harder for private sector companies to raise capital easily and at the lowest possible cost. The market gyrations also threaten to introduce uncertainty into what traditionally has been the preferred asset class for pension funds, retirees and others looking for the safest possible investment returns. This in turn adds to the risks for the broader economy that eventually may force central banks to change their plans. August will see the remainder of the 2Q 2022 earnings season, as well as a slew of key economic data, including CPI prints on August 10.
WTI Crude declined 4.3% in July after a 5.5% in June and a streak of six consecutive monthly gains. WTI closed July at $99/bbl but remains up 49.1% YTD.
Despite the ongoing crisis, which includes high-profile bankruptcies, problems with crypto lenders, and worries about inflation and rising interest rates, Bitcoin, the leading cryptocurrency, rebounded from its 2022 June lows. It finished July with an impressive 27.5% rally to $23,881. Ethereum did even better with a positive 68.5% return in July.
The CBOE Volatility Index (VIX), a popular measure of the stock market’s expectation of volatility based on S&P 500 index options, came down from 28.7 to close the month of July at 21.3, its lowest level since April 2022.
Chart of the Month – CPI Inflation vs. Inflation Expectations
The Fed’s mandate is to achieve maximum employment and price stability. It defines the latter as an annual inflation rate of 2%, on average. To help achieve that goal, it strives to “anchor” inflation expectations at roughly 2%. Inflation expectations are the rate at which people – consumers, businesses, investors – expect prices to rise in the future. Inflation expectations matter because actual inflation depends, in large part, on what we expect it to be.
Inflation, as measured by the headline CPI (Consumer Price Index), is now more than three standard deviations above the long-term average at 9.1% year-on-year, the highest level since the eighties, on a tight labor market, supply chain disruptions, and rising commodity prices. Analysis of the CPI suggests that inflation is the result of both potentially transitory (supply chain) and more persistent (wages and rents) components. The Fed expects the transitory price pressures to resolve over time – hence, they will focus on the persistent components when deciding how fast and how high to raise interest rates.
Inflation, as measured by the CPI – which is backwards looking – is uncomfortably high, but inflation expectations – which are forward looking – as measured by the Fed 5-year 5-year forward breakeven, remain relatively well anchored as illustrated below.
Quote of the Month
“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen It for 10 years.”
– Warren Buffet
Major Asset Class Dashboard
Important Disclosure: This report is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. All investments involve risks, including the loss of principal. Investors should consult with their financial professional before making any investment decisions. Past performance is not a guarantee of future results.
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